What is your most valuable asset? Is it your house? Your 401(k)? Your savings account? For most people, although they may not realize it, their biggest asset by far is their ability to earn an income. If their earned income were to stop, their whole life would fall apart.
If you make $250,000 per year and plan to work another 20 years, your ability to earn an income is worth at least $5,000,000. If your income goes up by only 3% per year, then you will have earned more than $6,700,000 total over 20 years. How does that compare to the value of your house, which many people think is their biggest asset?
Let’s say your house is currently worth $500,000. That would equal only two years of your current income. If it appreciates by 3% over the next 20 years, then the value would grow to a little over $900,000, which is less than one-seventh of the total value of your earned income over that same time period.
What are you doing now to protect your ability to earn an income? Could you afford to take a two-year vacation right now? If not, how would you cope if you could not work for two years or longer because of sickness or injury? The most practical and economic solution might be a long-term disability insurance policy, unless you already receive enough passive investment income to meet all of your obligations without working.
Would you ever buy a house without insuring it? Most people would not, even though the chances of a total loss are extremely low, and the financial impact of having to pay out of pocket to rebuild it themselves would not be nearly as devastating as losing their income for several years would be. What are the odds of not being able to work for an extended period due to sickness or injury? Much higher than the probability of your home burning down, and the consequences would be far more devastating. Therefore, I recommend that you acquire the maximum amount of disability insurance for which you can qualify.
According to the Council for Disability Awareness, a healthy 35-year-old male working in an office job with some outdoor physical responsibilities has a 21% chance of becoming disabled for three months or longer during his working career. The average length of disability for men in that category is almost seven years.[i] The likelihood of incurring a disability is even higher for men who are older or not as healthy. Over 90% of disabilities are caused by illness, not accident, so people with low-risk office jobs like mine are not immune to potential income loss due to disability.[ii]
Most insurance companies will replace 50-70% of lost income, depending on your annual income and profession. However, if the premiums are paid with after-tax dollars, the benefit is 100% tax-free, so a 60% benefit might feel more like an 80% replacement of take-home pay. Be sure to choose a long benefit period (to age 65 or longer), long elimination period (90 days or longer), inflation-adjusted benefit (COLA), and residual rider that will pay a portion of your benefit if you are working part-time. Also be sure that your policy covers your specific occupation for the rest of your life and that it is non-cancelable, which means the premiums can never be increased for any reason.
[i] CDA Personal Disability Quotient (PDQ) calculator, <http://www.disabilitycanhappen.org/chances_disability/pdq.asp> (21 March 2012).
[ii] Council for Disability Awareness, Long-Term Disability Claims Review, 2011, <http://www.disabilitycanhappen.org/research/CDA_LTD_Claims_Survey_2011.asp> (21 March 2012).
Adam Dawson, CFP® is a Principal at Capstone Capital and the author of Timeless Principles of Financial Security.